Portfolio implications of systemic crises |
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| Institution: | 1. Econometric Institute, Erasmus University Rotterdam, P.O. Box 1738, 3000 DR Rotterdam, The Netherlands;2. Department of Financial Management, RSM Erasmus University, P.O. Box 1738, 3000 DR Rotterdam, The Netherlands;1. Eller College of Management, The University of Arizona, Tucson 85721, United States;2. Spears School of Business, Oklahoma State University, Tulsa, OK 74106, United States;1. University of Amsterdam, Amsterdam School of Economics, Netherlands;2. Tilburg University, Department of Econometrics and OR, Netherlands;1. Economics Department, Carleton University, Ottawa, Canada;2. Centre for Econometric Analysis, Faculty of Finance, Cass Business School, City University London, UK;3. Department of Management, Economics and Quantitative Methods, University of Bergamo, Italy;1. University of Oldenburg, Department of Economics and Law, 26111 Oldenburg, Germany;2. University of Vienna, Faculty of Business, Economics and Statistics, Oskar Morgenstern Platz 1, Room 4.635, 1090 Wien, Austria;1. Queen Mary University of London, School of Business and Management, Mile End Road, London E1 4NS, UK;2. Kent Business School, University of Kent, Canterbury, Kent CT2 7PE, UK;3. Department of Economics, University of Thessaly, Korai 43, 38333, Volos, Greece |
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| Abstract: | Systemic crises can have grave consequences for investors in international equity markets, because they cause the risk-return trade-off to deteriorate severely for a longer period. We propose a novel approach to include the possibility of systemic crises in asset allocation decisions. By combining regime switching models with Merton Merton, R.C., 1969. Lifetime portfolio selection under uncertainty: The continuous time case. Review of Economics and Statistics 51, 247–257]-style portfolio construction, our approach captures persistence of crises much better than existing models. Our analysis shows that incorporating systemic crises greatly affects asset allocation decisions, while the costs of ignoring them is substantial. For an expected utility maximizing US investor, who can invest globally these costs range from 1.13% per year of his initial wealth when he has no prior information on the likelihood of a crisis, to over 3% per month if a crisis occurs with almost certainty. If a crisis is taken into account, the investor allocates less to risky assets, and particularly less to the crisis prone emerging markets. |
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